The Four Pillars of Investing: Lessons for Building a Winning Portfolio_9 pdf

Relish the RandomnessRealize that almost all apparent stock market patterns are, in fact, justcoincidence.. Accept the fact that stock market patterns are a chimera: the man inthe moon,

that you can’t check on its value every day, or even every year Youhappily hold onto it, oblivious to the fact that its actual market valuemay have temporarily declined 20% on occasion.

Ben Graham observed this effect when he noted that during theDepression, investors in obscure mortgage bonds that were not quot-

ed in the newspaper held on to them They eventually did wellbecause they did not have to face their losses on a regular basis in thefinancial pages On the other hand, holders of corporate bonds, whichhad sustained less actual decrease in value than the mortgage bonds,but who were supplied with frequent quotes, almost uniformly pan-icked and sold out

The other way to avoid myopic risk aversion is to hold enough cash

so that you have a certain equanimity about market falls: “Yes, I havelost money, but not as much as my neighbors, and I have a bit of drypowder with which to take advantage of low prices.”

At the end of the day, the intelligent investor knows that the

viscer-al reaction to short-term losses is a profoundly destructive instinct Helearns to turn it to his advantage by regularly telling himself, each andevery time his portfolio is hit, that low prices mean higher futurereturns

There Are No Great Companies

This is really just another variant of “Dare to Be Dull.” It is relativelyeasy to make the great company/great stock mistake Everyone wants

to own the most glamorous growth companies, when in fact historyteaches us that the dullest companies tend to have the highest returns

In the real world, superior growth is an illusion that evaporates fasterthan you can say “earnings surprise.” Yes, in retrospect it is possible

to find a few companies like Wal-Mart and Microsoft that have duced long-term sustained earnings increases, but the odds of your

pro-picking one of these winning lottery tickets ahead of time from the

stock pages are slim

Instead, you should consider overweighting value stocks in yourportfolio via some of the index funds we’ll describe in the last section.Unfortunately, we’ll find out in Chapter 13 that this isn’t always possi-ble, either for reasons of tax efficiency or because of your employmentsituation But at a minimum, beware the siren song of the growthstock, particularly when people begin talking about a “new era” ininvesting To quote my colleague Larry Swedroe, “There is nothingnew in the markets, only the history you haven’t read.”

Behavioral Therapy 185

Relish the Randomness

Realize that almost all apparent stock market patterns are, in fact, justcoincidence If you dredge through enough data, you will find anabundance of stock selection criteria and market timing rules thatwould have made you wealthy However, unless you possess a timemachine, they are of no use The experienced investor quickly learnsthat since most market behavior is random, what worked yesterdayrarely works tomorrow

Accept the fact that stock market patterns are a chimera: the man inthe moon, the face of your Aunt Tillie in the clouds scudding over-head Ignore them When dealing with the markets, the safest andmost profitable assumption is that there are no patterns While thereare a few weak statistical predictors of stock and market returns, most

of the financial world is totally chaotic The sooner you realize that nosystem, guru, or pattern is of benefit, the better off you will be.Most importantly, ignore market strategists who use financial andeconomic data to forecast market direction If we have learned any-thing over the past 70 years from the likes of Cowles, Fama, Graham,and Harvey, it’s that this is a fool’s errand Barton Biggs’s job is tomake Miss Cleo look good

Unify Your Mental Accounting

I guarantee you that each month, quarter, year, or decade, you will haveone or two asset classes that you will kick yourself for not owning more

of There will also be one or two dogs you will wish you had never laideyes on Certain asset classes, particularly precious metals and emerg-ing markets stocks, are quite capable of losing 50% to 75% of their valuewithin a year or two This is as it should be Do not allow the inevitablesmall pockets of disaster in your portfolio to upset you In order toobtain the full market return of any asset class, you must be willing tokeep it after its price has dramatically fallen If you cannot hold ontothe asset class mutts in your portfolio, you will fail The portfolio’s thething; ignore the performance of its components as much as you can

Do not revel in your successes, and at least take note of the bad

results Your overall portfolio return is all that matters At the end of

each year, calculate it.1If your math skills aren’t up to the task, it’s wellworth paying your accountant to do it

186 The Four Pillars of Investing

1 Here’s how If there are no additions to or withdrawals from you portfolio, simply divide the end value by the beginning value and subtract 1.0 For example, if you start-

ed the year with $10,500 and ended with $12,000, your return was (12,000/10,500) ⫺

Don’t Become a Whale

Wealthy investors should realize that they are the cash cows of theinvestment industry and that most of the exclusive investment vehiclesavailable to them—separate accounts, hedge funds, limited partner-ships, and the like—are designed to bleed them with commissions,transactional costs, and other fees “Whales” are eagerly courted withimpressive descriptions of sophisticated research, trading, and taxstrategies Don’t be fooled Remember that the largest investmentpools in the nation—the pension funds—are unable to beat the mar-ket, so it is unlikely that the investor with $10 million or even $1 bil-lion will be able to do so

My advice to the very wealthy? Swallow your pride and make that

800 call to a mutual fund specializing in low-cost index funds Mostfund families offer a premium level of service for those with seven-fig-ure portfolios This is probably not exclusive enough for your tastesbut should keep you clear of most of the unwashed masses and earnyou returns higher than those of your high-rent-district neighbors

CHAPTERS 7 AND 8 SUMMARY

1 Avoid the thundering herd If you don’t, you’ll get trampled anddirty The conventional wisdom is usually wrong

2 Avoid overconfidence You are most likely trading with investorswho are more knowledgeable, faster, and better equipped thanyou It is ludicrous to imagine that you can win this game byreading a newsletter or using a few simple selection strategiesand trading rules

3 Don’t be overly impressed with an asset’s performance over thepast five or ten years More likely than not, last decade’s loser will

do quite well in the next

4 Exciting investments are usually a bad deal Seeking ment from your investments is liable to lead you to the poor-house

entertain-Behavioral Therapy 187

1.0 ⫽ 0.143 ⫽ 14.3% If you had inflows or outflows during the year, this must be adjusted for (This is the mistake made by the Beardstown Ladies, who did not make this correction.) This is done by first calculating the net inflow In the above example,

if you added $1,000 and then took out $700 during the year, your net inflow was $300 You subtract half of this, or $150, from the top of the fraction, and add one-half to the bottom So, (12,000 ⫺ 150)/(10,500 ⫹ 150) ⫽ 1.113; your return was 11.3% If you had

a net outflow of $300, then you do the reverse—add to the top, subtract from the

bot-tom So, (12,000 ⫹ 150)/(10,500 ⫺ 150) ⫽ 1.174; your return was 17.4%.

5 Try not to worry too much about short-term losses Focus instead

on avoiding poor long-term returns by diversifying as much asyou can

6 The market tends to overvalue growth stocks, resulting in lowreturns Good companies are not necessarily good stocks

7 Beware of forecasts made on the basis of historical patterns.These are usually the results of chance and are not likely to recur

8 Focus on your whole portfolio, not the component parts.Calculate the whole portfolio’s return each year

9 If you are very wealthy, realize that your broker will likely do hisbest to bleed you with vehicles featuring excessive expenses andrisks

188 The Four Pillars of Investing

P ILLAR F OUR

The Business of Investing

The Carny Barkers

Unless you are going to be trading stock and bond certificates withyour friends, you will be forced to confront the colossus that bestridesthe modern American scene: the financial industry And make no mis-take about it, you are engaged in a brutal zero-sum contest with it—every penny of commissions, fees, and transactional costs it extracts isirretrievably lost to you

Each leg of this industry—the brokerage houses, mutual funds, andpress—will get its own chapter Their operations and strategies aresomewhat different, but their ultimate goal is the same: to transfer asmuch of your wealth to their ledger books as they can The brokerageindustry is the most dangerous and rapacious, but also the easiest to

deal with, since it can be bypassed completely You will have to deal

with the fund industry, and we’ll discuss the lay of the land in this vitalarea

More than seven decades ago, journalist Frederick Allen observedthat those writing the nation’s advertising copy wielded more powerthan those writing its history Ninety-nine percent of what you read

in and hear from the financial media is advertising cloaked as nalism

jour-In our modern society, it is impossible to avoid newspapers, zines, the Internet, and television You will need to understand howthe financial media works and how it plays a central role in the sur-vival of the brokerage and fund industries

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Your Broker Is Not Your Buddy

A broker with a clientele full of contented customers was—and is—a broker who will

soon be looking for a new job Brokers need trades to make money

Joseph Nocera, from A Piece Of The Action

191

Imagine for a moment that you’re a businessman who’s been assigned

by your company to a small country in eastern Europe Let’s call itChurnovia (It neighbors Randomovia, which you heard about earlier.)Although you find the climate, culture, and cuisine to your liking, you

do wonder about the nation’s legal system After all, Churnovia hasonly recently emerged from the shadow of the former Soviet Union,and legal concepts such as property and contractual obligation are not

as well developed as they should be

One day, you feel a belly pain and, by the time you are rushed tothe hospital, you are in agony You are whisked into surgery whereyour appendix is removed You seem to recover rapidly and are quick-

ly discharged home But your spouse notices something curious while

you’re asleep: your abdomen seems to be ticking Sure enough, you

go into a quiet room and are able to detect a faint, regular noise nating from your midsection

ema-You return to your surgeon and report this unusual observation.After replacing the stethoscope into his white coat, he nonchalantlyreplies, “Oh yes, it’s not unusual for bellies to tick after a bout ofappendicitis.” You are not impressed, and your concern increases asyour pain gradually returns, this time accompanied by high fever.Your faith in Churnovian medicine shaken, you fly home, wheredoctors remove a wristwatch surrounded by a sack of infected tissue.This time, your recovery is not as rapid, and you are confined to thehospital for many weeks of antibiotic therapy It is months before youcan return to work You begin to wonder about legal recourse andconsult an expert in international law

His report is not sanguine “You see, there’s a big differencebetween Churnovian and American medicine For starters, doctorsthere have no firm educational requirements You don’t even have to

go to medical school Some, in fact, have never completed highschool All you have to do is cram for a multiple-choice exam, whichyou can take as many times as you need in order to pass And as soon

as you pass, you can hang out a shingle What’s worse, Churnoviandoctors owe no professional duty to their patients They can easily getaway with performing unnecessary surgeries for financial gain Also,when things go wrong, they aren’t held to a particularly high standard

And here’s the pièce de résistance: upon entering the hospital you

signed an agreement to submit all disputes to an arbitration boardwhose structure is mandated by the Churnovian Medical Association.I’m sorry, but I’d be a fool to take your case.”

Sound farfetched? It isn’t Once you step inside the office of a retailbrokerage firm, you might as well be in Churnovia Consider:

• There are no educational requirements for brokers (or, as they’reknown in the business, registered reps) No mandatory courses infinance, economics, law, or even a high-school diploma are nec-essary to enter the field Simply pass the pathetically simple Series

7 exam, and you’re on your way to a profitable career In fact,having gotten this far in the book, you know far more about thecapital markets than the average broker I have yet to meet anybrokers who are aware that small-growth stocks have low returns,

or who are familiar with the most basic principles of portfolio ory I have never met a broker who was aware of the corrosiveeffect of portfolio turnover on performance And I have yet toencounter one who is able to use the Gordon Equation to esti-mate returns

the-• Brokers have no fiduciary responsibility toward their clients.Although the legal definition of “fiduciary” is complex, this basi-cally means the obligation to always put the client’s interests first.Doctors, lawyers, bankers, and accountants all owe their clientsfiduciary responsibility Not so stockbrokers (Investment advisorsdo.)

• There are few other professions where the service provider’sinterest is so different from the client’s Not even HMO medicinecontrasts the welfare of providers and consumers as starkly.While you seek to minimize turnover, fees, and commissions, it’s

in your broker’s best interest to maximize these expenses A hoaryold broker adage expresses this objective perfectly: “My job is toslowly transfer the client’s assets to my own name.”

192 The Four Pillars of Investing

• Almost all brokerage houses have you agree, at the time of ing your account, to resolve any future legal disputes via arbitrationbefore the New York Stock Exchange, Inc or NASD Regulation,Inc., in other words, the brokers’ own trade groups.

open-In the following pages, we’ll survey the sorry story of the brokerageindustry and how its interests and yours are diametrically opposed

The Betrayal of Charlie Merrill

By any measure, Charles Edward Merrill was a spirited visionary Yet

he certainly did not fit the stereotype Self-aggrandizing and overlyfond of carousing, strong drink, and other men’s wives, he nearly sin-gle-handedly pioneered the financial services industry in the periodsurrounding World War II The rise and fall of his dream—the broker-age company as public fiduciary—is a story worth telling

Born in 1885, Merrill entered the brokerage business after droppingout of Amherst and quickly built a successful investment banking andretail brokerage firm Merrill was repulsed by the corrupt financial cli-mate of the late 1920s, with its bucket shops and overt stock manipula-tion, and strove to be different Wall Street then was the ultimate insid-er’s poker game in which the investing public invariably played thesucker The 1929 crash produced a wave of popular revulsion againstthe brokerage industry and resulted in the passage of the Securities Acts

of 1933 and 1934, and the Glass-Steagall Act, which still shape the cial industry today But for decades before this, Charlie Merrill knewthere was something wrong, and he wanted to fix it In 1939 he got hischance, accepting the leadership of a new firm: the merged Merrill,Lynch & Co and E.A Pierce and Cassatt, later renamed Merrill Lynch.Merrill undertook the job with relish and made it his mission torestore public confidence in the brokerage industry—in short, to

finan-“bring Wall Street to Main Street.” This was a tough row to hoe, andhis methods were nothing short of revolutionary First and foremost,

he paid his brokers by salary, not commissions Since the first “stockjobbers” began plying their trade in the coffeehouses of London’sChange Alley in the late seventeenth century, brokers had made theirliving by “churning” their clients—encouraging them to trade exces-sively in order to generate fat fees

Merrill wanted to send a message to the investing public that his kers were different from the commission-hungry rogues of his competi-tors By contrast, his salaried employees would act as the objective, dis-interested stewards of the public’s capital He would not charge for col-lecting dividends, as did other “wirehouses” (as brokerage firms, which

bro-Your Broker is Not bro-Your Buddy 193

communicated over private phone lines, were known) Commissionswould be the minimum allowed by the exchange Although high bytoday’s standards, a Merrill customer would get rates offered only thebiggest clients at other firms A Merrill broker would always disclose thecompany’s interest in a particular stock, something that was notrequired by law and unheard of elsewhere in the industry (and rarelydone even today) Hot tips were replaced by analytic research.

Merrill’s revolution succeeded By the time he passed away in 1956,Merrill Lynch had grown into the nation’s largest wirehouse, with 122offices, 5,800 employees, and 440,000 customers Yet Merrill died anunhappy man

First and foremost, although Merrill Lynch had made the mass ket transition, the rest of Wall Street had not yet made it to Main Street

mar-It gave the old man no satisfaction to be the leader of a failed, ward industry But more importantly, the rest of Wall Street continued

back-to treat the client as it always had: not as an object of respect, worthy

of the most effective and efficient investment product, but instead as

a “revenue center.”

Worse was still to come Donald Regan (who later became TreasurySecretary) took over the reins at Merrill in 1968 The markets werebuoyant that year Then, as now, tech stocks were all the rage and trad-ing volume was high, at least by the standards of the day Brokers atother firms, all of whom worked on a commission basis, were makingmoney like it was going out of style But there was no joy at Merrill,where the brokers were salaried Defections mounted, and within ashort time after assuming power, Regan was forced to join the rest ofthe industry and allow his troops a piece of the commission action.Thus was Merrill’s legacy betrayed, along with its clients In the shortrun, Regan had saved the company; the defections stopped and prof-itability returned Trading volume at Merrill skyrocketed as it becamejust like everyone else At the same time, the company ceased treatingits clients’ interests as a sacred trust and turned them into cash cows

to be methodically milked for commissions

This was the end of the trail for the modern retail brokerage firm as

a socially useful enterprise It fell to others, notably Ned Johnson atFidelity and Jack Bogle at Vanguard, to later champion inexpensiveaccess to the markets for the average investor We’ll examine thatstory—the rise of the mutual fund industry—in the next chapter

Stockbroking’s Seamy Underside

Few industries are as opaque to serious study as retail brokerage Themost basic data pertaining to broker background and performance,

194 The Four Pillars of Investing

portfolio turnover, and expense simply do not exist It is truly ishing that the SEC, charged with protecting the public interest in thecapital markets, collects little information about the level of perform-ance, fees, turnover, and other expenses in the industry And it seems

aston-to have little interest at all in the training and level of knowledge ofbrokers as a group It is a sad fact that you can pass the Series 7 examand begin to manage other people’s accumulated life savings fasterthan you can get a manicurist’s license in most states

The brokerage industry itself is extremely tight-lipped about fees,performance, and corporate practices Because of this, we are forced

to look at the indirect evidence—anecdotal descriptions of the cations, training, incentives, and culture at the big wirehouses Eventhe most cursory study reveals that there is very good reason for thesecrecy

qualifi-The first observation is the most obvious As we’ve already cussed, your investment return, on average, will be the market returnminus your expenses Does it have to be said that your broker has anincentive to keep those expenses—the nearly exclusive source of hisincome—as high as possible? For proof, just look at what brokers doand don’t recommend to their clients Rarely are Treasury securitiesrecommended, because they carry minuscule commissions And youwill almost never see a broker suggest a no-load fund

dis-Principal Transactions Are Not Principled Transactions

There is a lot of confusion about one source of a broker’s income—spreads A stock or bond does not have one price, but two: the lower

“bid” and the higher “ask.” You buy at the higher ask price and sell atthe lower bid price The difference between the two is small for heav-ily traded stocks, typically less than 1% of the purchase price, and largefor thinly traded stocks—as much as 6% of the price Thus, every timethe investor buys, then later sells a stock or bond, he loses the spreadbetween the bid and the ask price The spread goes to the “marketmaker,” the person or company that at all times maintains an invento-

ry of the stock or bond, to allow for smooth trading

In many cases, the broker is acting as an “agent,” which means that

he and his company are not the market makers Instead of getting the

spread, they trade with the market maker and collect a commission forthis service But frequently the broker acts as “principal,” meaning thathis firm is, in fact, the market maker, buying from and selling to itsown clients In this case, they do collect the spread and are notallowed to also charge a commission (Although illegal, the charging

of a commission on a principal transaction—“double dipping”—is not

Your Broker is Not Your Buddy 195

a rare occurrence.) This is usually noted on the trade confirmation as

a “principal transaction.” And here is where most of the skullduggeryoccurs

Profit margins are quite high with principal transactions—the clientalmost never finds out that the stock or bond he just purchased wasacquired from another of the firm’s customers at a much lower price.Clients are told simply that “there is no commission” on principal trans-actions, as if they have just benefited from an unexpected bit of cor-porate largess

Even worse, many wirehouses’ principal transactions take the form

of “specials”—undesirable stocks and bonds underwritten or chased in quantity by the firm and passed off on clients via brokerstouting glowing research reports from the company’s crack analysts.Brokers who can unload large amounts of such toxic waste on theirunsuspecting clients are rewarded with bonuses and prizes (typicallyexotic vacations) I have never seen a broker-run account that was notlaced with obscure, illiquid stocks and bonds carrying high commis-sions and spreads; these securities have “special” written all over them.Sadly, clients are never told that such transactions involved a special.Most brokerage houses also sell mutual funds These almost alwayscarry a sales fee, or “load.” As we’ll see in the next chapter, load funds

pur-do not perform any better than funds sold without a sales fee—known

as “no-load funds.” Yet, brokers almost never recommend no-loadfunds, for obvious reasons

Have you ever wondered how your broker comes up with his ommendations? Do you think that he carefully analyzes the market,stock by stock, looking over each company’s fundamental financialdata, industry trends, and marketing data? Hardly The average broker

rec-is a salesman, not an expert in finance Your broker’s stock picks comestraight from the “squawk box,” a loudspeaker that connects everybranch to headquarters Several times a day, the firm’s industry ana-lysts and strategists report their conclusions simultaneously to thou-sands of brokers around the country Later that day, or that week, youget the hot tip from your broker

The problem is that you, as a small retail customer, are last in line.The large institutional players—pensions, privately managed money,and mutual funds—have received the news long before you, and theprice of the stock has already been bid up by the time your brokerphones you with the recommendation In this poker game, you’re thepatsy But you’re in good company, because the analyst’s recommen-dations are already tainted The world of brokerage stock analysis is asmall, inbred one At its center are the corporate officers who dole outfinancial information about their companies to the analysts Not only

196 The Four Pillars of Investing